The topic of equalization evokes warm feelings among many Canadians. It appeals to a fuzzy mystique about a Canadian way of "caring and sharing," about richer parts of the country spreading around their good fortune, and about guaranteeing similar levels of public services to all Canadians.
The truth, however, is that Canada's complex and unwieldy equalization program is an example of good intentions gone wrong.
The program, established in 1957, was designed to transfer revenue from the more prosperous "have" to the less prosperous "have-not" provinces. Its stated objective is "ensuring reasonably comparable levels of public services at reasonably comparable levels of taxation." In theory, the program transfers resources to poorer provinces so they can fund services without excessively taxing their own residents.
While this is noble in intent, there are many practical difficulties in calculating tax bases within an ever-changing national economy. Moreover, even though the transfer formula has been continuously retooled, it continues to encourage economically destructive policies in recipient jurisdictions. The rules governing Canada's equalization program come up for renegotiation in 2014. The provinces and the federal government should treat this as a golden opportunity to transform fiscal federalism in Canada, and redress its many unintended consequences.
Equalization, viewed critically, does no favours to either the funding or recipient provinces. After 50 years, outside transfers constitute an ever larger portion of the economies in have-not provinces. In an otherwise globally-oriented, market-driven world, Canada's equalization program has encouraged the development of locally-oriented, public-sector driven economies.
Here are just a few ways that equalization provides incentives to harmful policy, stunting economic growth in the jurisdictions the policy means to help.
- Inflating the Public Sector. Equalization has allowed recipient jurisdictions to create disproportionately larger public sectors because someone else is paying the bill. Manitoba's public sector, for instance, employs 103 people per 1,000 residents, compared to a Canadian average of 84.
- Politicizing Spending. The external funding from equalization has allowed local politicians to build up vote-buying infrastructure with little political cost, by disconnecting taxation from benefit. Quebec's 7-dollar-a-day daycare, and university tuition at less than half the Canadian average, would be unworkable without $7.4 billion in annual equalization subsidies from the rest of Canada.
- Incentives for Higher Taxes. A path-breaking study by the Atlantic Institute for Market Studies showed that equalization rewards recipient provinces for imposing high and damaging tax rates, which deter private sector investment and job creation. Manitoba, the only have-not province in western Canada, has the highest income taxes in the region, also has the lowest rate of private-sector investment.
- Artificially Inexpensive Hydro power. By excluding the true value of renewable hydro energy revenues from the calculation of revenue capacity, the equalization formula rewards Manitoba and Quebec for charging artificially low domestic electricity prices. Below-market prices, in turn, encourage consumers to use more resources that otherwise would be conserved in response to accurate price signals.
Most Canadians may find it surprising that equalization encourages Quebec and Manitoba to waste renewable energy – so let's walk through the logic.
When provinces develop new revenue capacity, equalization receipts generally go down, because the jurisdiction is deemed to have become less needy under the applicable formulae. Newfoundland and Saskatchewan, for instance, once were deemed have-not provinces until booming oil revenues pushed them into the have category. Rising resource revenues were clawed back from equalization payments until no more payments were forthcoming.
But a quirk in the equalization formula excludes the true value of hydro electric energy produced by Manitoba and Quebec, which sell their hydropower in local markets for below-market prices without penalty. An analogy would be Saskatchewan selling its oil, with a market value of about 95 dollars a barrel, in its local market for 50 dollars. The formula is correct to deduct the market price of oil (95$) rather than the artificially low price ($50 in this example) from any equalization payments. The same logic should apply to Quebec and Manitoba's hydro revenues under the equalization rules – but doesn't. By creating a massive financial incentive for Quebec and Manitoba to subsidize hydro power heavily, the current arrangements generate market inefficiencies and encourage resource waste.
Between 2005 and 2010, Quebec received $42.4 billion in equalization. Lost revenues resulting from excessively low electricity pricing during that period was $28.6 billion. Since the equalization formula deducts 50% as a clawback from additional resource proceeds, an extra $14.3-billion (half of $28.6-billion) should have been deducted from Quebec's equalization if its hydro revenues were treated the same as Alberta's oil revenues under the rules. That would yield total equalization payments of $28.1-billion instead of $42.4-billion for the 2005-2010 period.
In other words, the federal government paid 34% more equalization to Quebec that it should have under more equitable rules. Alberta and Ontario taxpayers are effectively paying Quebec (and Manitoba) to consume artificially inexpensive power. (While Ontario now receives equalization payments, it remains a major net contributor to the system.)
The upcoming 2014 negotiations present an opportunity to normalize the treatment of electricity in the equalization formula, and fix this long-standing problem without major disruptions to have-not provincial budgets. That is because the high dollar, soft US economy and low prices for natural gas have depressed power rates in the US and therefore the rate of subsidization in Canada. A basic minimum reform of equalization should make hydro revenues subject to the same treatment as revenues from non-renewable sources such as oil extracted in Newfoundland, Saskatchewan and Alberta.
The downside is that this adjustment will add yet more complexity to an ever-more unwieldy and counter-productive transfer payment program. So, instead of applying patches to deal with specific unintended consequences such as the one just described, the ideal scenario in the 2014 negotiations would be for our governments to recognize that equalization's so-called benefits are illusory. Instead of "ensuring reasonably comparable levels of public services at reasonably comparable levels of taxation," equalization has stimulated the development of bloated, public-sector-dominated high-tax economies, and created a corrosive dependency syndrome in have-not provinces.
What is needed is a simple but comprehensive solution that allows local politicians to offer their citizens a more transformational policy model. For example, transferring the GST proceeds to the provinces in exchange for eliminating equalization would free the have-nots from the program's perverse incentives. Monies raised locally would render local governments more responsive and accountable, and these local governments would feel the pressure to stimulate greater local growth as a means to increase revenue. The cycle of regional dependency would be broken.
The 2014 negotiations present an opportunity for Canada's political leadership to reform fiscal federalism. Such opportunities come along infrequently. Let's not allow this one to slip away.
This is the second of a five part series in the National Post, in which experts from Canada's leading think tanks make the case for reforming Canada's system of inter-governmental transfer payments.